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Why EVA Expectations Aren't Always Realized in Transactions

This newsletter is devoted to the pursuit of Economic Value-Add (EVA) in business – how it is useful, its impact, and how it’s used in businesses. At the high-level, EVA will reveal anticipated levels of economic impact from making decisions, and in this instance, the accretive (or not) nature of a transaction. Similarly, after arriving at an EVA calculation, leaders can assess the impact one transaction may have on the business versus another as capital is generally not limitless and decisions must be made. So, with a solid metric like EVA in place – why is the anticipated EVA not always realized post transaction?

EVA is comprised of two primary components: a) net operating profit after tax (NOPAT) (though many PE backed groups may review this on both pre- and post-tax bases) and b) the finance charge with the significant component representing the amount of capital invested in a transaction. When assessing a transaction and planning for the impact, the NOPAT must be estimated including planned synergies, required investments, and the anticipated performance of the business. The finance charge will include assumptions as a result of the transaction and may require a change in the capital structure – and a change therefore to the WACC – as well as estimating any transaction related expenses which would be included in the amount of capital invested in a transaction.

If we are focusing on the two primary components of EVA, how then can we not realize the anticipated EVA? Simply, estimates of the impacts, needs, and performance of transactions are often quite wrong. In most organizations, if the team has become bullish on a transaction or particularly likes the team being acquired, the performance will be over-estimated, the costs and expenses needed to integrate will be higher than planned, and performance variations will be explained away without updating estimations and expectations of the business.

The business of integrating companies together is taxing – both from the physical and emotional component as well as the capital required to do so. Planned acquisitions and integrations include budgets and expected costs to integrate a business, but often underestimate the costs. These costs should be included in the finance charge (capital invested) component of EVA for an acquisition. However, if these estimates are too low initially, the capital investment estimate will be artificially low, and the EVA metric will reflect a higher value than is realistic. These transaction related expenses must be analyzed for each transaction – leveraging historical information – but also taking into consideration the nuances of an individual transaction.

An area where many underestimations have been occurring in recent history is for legal expenses. With an increased transaction volume nationally, legal resources are harder to come by. Supply-demand principles reflect the costs of legal services will therefore increase – which is occurring – but also transaction timelines are increasing and may cause other transaction related expenses to increase with the delayed timelines. For instance, Quality of Earnings reports may need to be updated, advisor groups may be retained for longer periods, and even interest rate changes may occur impacting the WACC.

So, what can businesses do? First and foremost, have an honest conversation regarding the expectations of a transaction. Deconstruct the estimates and assumptions for the transaction and challenge them. Secondly, develop a standard, appropriate methodology for estimating transaction expenses with realistic timelines, expenses, and support requirements. Third, stress-test business models on anticipated NOPAT (or even just NOP) to reflect realities of future performance and with any changes because of the transaction. Last, ensure the advisors you are working with are versed in the transactions being contemplated, constructively challenge your teams on estimates, and work with them to develop realistic expectations of the transaction.

At SLKone, we have assisted both corporate and PE-backed clients with over thirty transactions in the last four years. We have focused on assisting teams with planning for their transactions and with integration implementation and go-forward business changes. If this sounds like something your business would benefit from, please reach out to learn more today.